Dec. 26, 2012

 

It would be thought a hard government that should tax its people one tenth part.

Benjamin Franklin

As originally written, the income tax laws did not attempt to tax the common worker or the wages and salaries received in exchange for the products derived from that labor. Common sense dictates that the wages and salaries of common workers could not have been the subject of the income tax laws. The entire reform movement of enacting an income tax was to tax the unearned incomes of the rich and the profits and gains of corporations and trusts, not the remunerative wages and salaries of the common worker. Had the latter been the case there would have been instantaneous revolt. The reformers of that day wanted to tax rich businessmen, not workers. Some people will note that the tax acts of 1861–1864 did indeed tax wages and salaries. But one also must recognize the unique situation of the day and perceived crisis that created a climate for such abuse. During a time of war few people are going to resist and fight such legislation. Legislators knew they were imposing a direct tax masked as a “duty.” Post-war discussions revealed likewise. Additionally. Mr. Lincoln had declared martial law, and was well known for incarcerating many people simply for their opinions against the war.

The 1913 law was intended to tax wealthy business professionals, proprietors, corporations, and certain passive unearned investments. The amount of tax owed was to be measured by net income.[1] This is obvious by examining an income tax return from 1913. The tax return of 1913 functioned similarly to the modern Schedule C. Although including a graduated “progressive” surtax, the minimum tax rate was a whopping 1 percent of individual and corporate net income in excess of the exemption amount.

Wages are the property an individual receives in exchange for the products of labor, (net) income is profit or gain. Fundamentally, wages are merely conversion of an asset, there can be no gain. In 1913 when wealthier individuals began paying the income tax, the intent was to tax the individual’s net income — net profit and gains from businesses, proprietorships, and investments. By this time readers should realize that if income is synonymous with profits and gain, then with respect to taxation the term net income is redundant.

Income is property but income also is a concept. Wages do not fit that same description. Wages are tangible, can be touched, and is an object. That observation would indicate that wages are not subject to an income tax. If wages were to be taxed, they would have to be taxed as normal property, and subject to the rule of apportionment.

Regarding individuals and excluding corporations, in the beginning of the income tax only well-to-do investors, proprietors, and professionals operating as a proprietorship, were subject to the tax. Such people tended to manage their businesses and professions using standard accounting principles that calculate and disclose a net income — gain. In those early days income was understood to be profit and gain and distinguished from wages. Nonetheless, the filing process itself opened the doors for later confusion of the terms. As tax rates changed, more middle-class professional individuals and proprietors became subject to the tax system, unfortunately including those people who were not so wealthy. As more and more less-wealthy individual business people became subject to the tax, the groundwork was laid to cloud the distinction between income and wages. Within one generation the distinction was gone. That the IRS glossed and “overlooked” that transition could be attributed to mere bureaucratic bungling and bloat, but accusations of nefarious motivations cannot be ignored.

One way or another, what once was considered the sacred property of the typical American — wages and salaries — was slowly being eroded under the guise of being called income. Americans only wanted organized business profits and certain forms of passive unearned incomes taxed and nothing more. Fortunately, for almost three decades, the typical American never realized wages or salaries that exceeded the exemption ceiling. The typical American did not pay a tax on incomes, although the meaning of the word had become fuzzy with respect to wages and salaries.

That fuzziness continued in 1935 and was complete after World War II.

In 1935 legislators enacted the Social Security Act.[2] The Supreme Court justices allowed this coercive wealth redistribution type of tax, but in Railroad Retirement Board v. Alton R. Company,[3] rejected the obvious coercive wealth redistribution of the Railroad Retirement Act of 1934.[4] Why? Because in R.R. Board, the money was being taken out of workers’ pay and diverted directly to retirees through a private fund. The justices rejected that idea, but then provided legislators a clue how to properly withstand their scrutiny. All the legislators need do was to levy the tax, then throw the money into the general treasury, and then disburse the monies through the legislative budgeting process. As long as the taxes went through the general treasury unmarked for any specific purpose, the justices would remain mute. And the justices remained true to their intimations. They upheld the new Social Security tax scheme in two pivotal 1937 cases: Steward Machine Co. v. Davis,[5] and Helvering v. Davis.[6] In Helvering v. Davis the Court justices distinguished between the two types of taxes levied. One tax was levied on the employee and the Court justices called that tax an income tax, measured by the wages received. The other tax is levied on the employer and the Court justices called that tax an excise tax. Why did the justices provide such a distinction? In Brushaber and Stanton the Court justices declared income taxes to be excise taxes. So why the difference? The camel’s nose began to grow.

In 1939, legislators enacted the first Internal Revenue Code,[7] merging all previous tax acts into one volume of text. This codification process opened the door to obfuscation because most people would reference the tax code rather than the original statutes and would not necessarily know if the original statutes were transcribed correctly into the code. That portions of the code have not been transcribed correctly becomes obvious to people who investigate the original statutes. Are such omissions and commissions deliberate or merely acts of ignorance and incompetence?

Also in 1939 congressional legislators enacted the Public Salary Tax Act.[8] In that act legislators did not directly impose a tax, but made state public employees subject to the federal income tax and consented to allow state income taxation on the salary and wages of federal employees. Previous to this point neither was subject to taxation, but with rising salaries in the public sector that in some cases exceeded that of the private sector, these employees were paying no taxes, a point which legislators thought unwise. These high wages and salaries, considered “positions of profit” because the amounts paid exceeded that of equivalent jobs in the private sector, were considered “excess” wages and salaries, consistent with the original manner in which legislators in 1913 had designed the $3,000 exemption ceiling.

However, throughout American history, the idea of taxing public employees was thought inefficient since they are paid from the general treasury. Taxes simply would have to go back to that same source. The prevailing wisdom was simply to pay modest wages and salaries to account for the difference from the private sector individuals who did pay taxes. Regardless, these salaries and wages became subject to an income tax for the first time in a direct manner. The legislative goal was to destroy the long-held doctrine, first popularized in McCulloch v. Maryland,[9] that state legislators could not tax federal entities and vice-versa. Add three Supreme Court cases, one in which the justices affirmed federal taxation of state employees’ salaries,[10] another in which they agreed state legislators could tax the salaries of certain federal employees,[11] and another where they affirmed taxing the salaries of federal judges,[12] and the ability to tax anyone anywhere was becoming a fast reality.

Although not yet engaged in the war in Europe or Pacific, in 1940 legislators enacted The Revenue Act of 1940, otherwise known as the “National Defense Tax Bill.”[13] Legislators modified the filing requirements. The income tax remained a tax on net income, but in order to accommodate the public employees then being taxed under the Public Salary Tax Act of 1939, who had to file a tax return was modified to gross receipts rather than net income.[14] The significant effect was that the ordinary and necessary expenses of life were then solely embedded within the statutory exemption rather than itemized and calculated by the potential taxpayer. This single change caused approximately 8 million new people to file tax returns. Legislators also lowered the exemptions from $1,000 and $2,500 for single and married to $800 and $2,000.[15] Legislators expected to pull in an additional 7 million taxpayers and $322 million.[16]

In 1941 legislators lowered the exemption rates to $750 for single and $1,500 for married couples.[17] In 1942 they further reduced the amounts to $500 and $1,200 respectively,[18] and reduced the exemption per dependents from $400 to $350.[19] To support the new war effort legislators had reduced the exemption ceiling to pull more people into the tax scheme. By the mere stroke of the pen and the illusion of this fiat statutory ceiling, millions of additional Americans suddenly were sucked into the income tax system. This was exactly the type of “elasticity” sought by legislators in the late 19th century. But in the middle of a war, much like during World War I, when many people believed they were fighting for their very existence, whether or not true, convinced most people to seal their lips and pay the tax. Doing so was considered “patriotic.”

A significant change in 1942 was the Victory Tax.[20] Legislators imposed a 5 percent tax levied on gross income of $624 or more, both public and private. This tax was separate from any normal income taxes a person might pay. The tax was imposed on the “victory tax net income.” For wage earners that meant the total wages received for the year and net income (profits and gains) for every other entity. This one tax would increase the number of filers by approximately 18.5 million people. Gross income was defined in the 1939 Internal Revenue Code at section 22(a): “Gross income includes gains, profits, and income derived from . . . .” Although the tax was specifically earmarked to end with the cessation of hostilities,[21] the tax was withheld at the source of payment.

Withholding at the source was not a new idea, having been used and tried before in the United States in 1862, 1894, 1913 and the taxes imposed by the Social Security Act of 1935. Withholding had roots in Britain as far back as 1803.[22] The withholding invoked in 1913[23] was repealed in 1917.[24] The primary reason was that the new income tax had not yet been widely accepted and resistance to the new type of tax still circulated.[25] Withholding was too much to swallow in a period when personal property and contracts were still highly regarded. Thirty years later, however, with the income tax well entrenched and limited withholding already in place, and another war in which politicians could cleverly hide behind the mantra of “patriotism,” withholding was more ripe for acceptance during those years.

In 1943 legislators enacted the Current Tax Payment Act,[26] which entrenched withholding of taxes at the source of payment. That act remains in effect today. Unlike the Social Security Act and the Victory Tax that withheld only particular taxes, the 1943 act would implement withholding in a more broad manner.

The changes of the 1942 and 1943 tax laws caught many people off guard. With many additional people suddenly faced with a tax bill never previously experienced, war or not, legislators and executives feared a tax revolt. Legislators realized that many people tended to ignore the total debt in any bill if they could pay in installments rather than lump sum. Therefore withholding was and is a psychological ploy such that people do not realize the total tax bill.[27] Beardsley Ruml, head of the Federal Reserve Bank of New York and company executive of the Macy department store chain, noticed from his retail experience that people disliked large bills of any kind.[28]

The withholding idea was sold to Americans as a benefit and propaganda was a major tool in convincing Americans to accept withholding.[29] “Installment payments” through withholding not only solved the problem of quashing a possible tax revolt, but circulated more currency into the treasury to support the war effort, which was the real reason for pursuing withholding. Politicians were spending money faster than they could collect and spending through the printing press of the central banking mechanism was producing rampant inflation. Withholding was intended to dampen currency inflation by removing currency from general circulation.[30] In reality, because the currency is merely moved from one class of people to another and still spent into circulation, inflation remains and the only effect is that the original creators of that currency are deprived of spending the fruits of their labor. With this withholding, the politicians would not have to pay as much interest as they would have had they borrowed the same amount. Milton Friedman, well-known economist and Nobel Laureate, was one of the people who recommended withholding to curtail inflation. To his credit, Friedman grew to understand the law of unintended consequences and years later recanted his decision.[31]

To sell the permanent withholding idea, to avoid people paying two years of taxes within the same year (the lump sum tax for the previous year and the new withholding taxes), to quash a potential tax revolt, and to bring more people into the tax scheme voluntarily, legislators promoted the idea that 75 percent of the taxes due for 1942 or 1943 would be forgiven. This talk was political sleight-of-hand. Although people who might have been liable for taxes in 1942 and did not pay seemed to escape a year of taxes, the withholding scheme brought those people into the system immediately.[32] The out-of-pocket effect was exactly the same. To help offset some of the noticeable psychological resistance to withholding, later legislators enacted the Revenue Act of 1943[33] — the first federal tax bill vetoed and then overridden — and reduced the Victory tax from 5 to 3 percent.[34] More subtle was the fact that legislators had been reducing the exemption ceiling, which effectively neutralized the original forgiveness.

Although many Americans still received wages and salaries that were not subject to taxes on income, they nonetheless suffered withholding under this new act. Such people would be required to file a tax return to claim a refund of the amounts withheld. Additionally, to generate more revenues for the war effort, legislators were purposely lowering the exemption ceiling and further exposing more wages and salaries to being classified as “excess” and a “gain” subject to taxation.

Included in the Individual Income Tax Act of 1944 was a new “standard deduction,”[35] which for many people eliminated the challenge of itemizing expenses. There no longer were distinctions between the three exemption rates as personal exemptions were all standardized to $500 per person.[36] Withholding was seen by many people as a wartime emergency. Because withholding was so successful, the 5 percent Victory Tax was explicitly repealed in the 1944 Tax Act rather than allowed to expire as defined in the original 1942 act.[37] Few people noticed the repeal because of the 1943 act permanently implementing withholding.

That same act also introduced the statutory term “adjusted gross income.”[38] That new term added another layer in confusing the intent of this tax. Legislators wanted to equalize the way in which individual humans and business owners filed tax returns. This is the continuing saga of legislators trying to impose more “efficient” or “scientific” laws. From the beginning of the modern income tax, people have viewed the system as one that can be regulated or perfected with a set of legal rules.[39] In order to equate wages and salaries with gross receipts, they invented the term “adjusted gross income” so that wages and salaries then could be merged with other forms of gross receipts or gross income. This new term replaced the then existing statutory term of “net income”:[40]

In general, adjusted gross income is gross income less business deductions, and for the average wage earner represents his total wages.

The acute problem with this effort is that wages and salaries were never “net income” as intended under the 16th Amendment and thus, never could be “adjusted gross income” either. Worse, legislators did not allow for wage and salary earners to deduct the ordinary and necessary costs of living, instead retaining the focus of deductions from the perspective of a business only. This sleight-of-hand equated wages and salaries (gross receipts) with business net income (profits and gains).[41]

 

The effects of this five-year period forever changed the overall perception of the income tax. War once again entrenched this tax into the American psyche. The tax was magically transformed from a “class tax” to a “mass tax.”[42] The number of returns filed in 1939 was approximately 4 million.[43] The reduced exemption ceiling in 1941 increased that number to 15 million. The lowering of the exemption ceiling and Victory Tax in 1942 brought in 16 million returns. The number of returns expected to be filed for 1943 was 35 million.[44] Overall, from 1940 to 1945 the number people required to file a tax return increased from less than 15 million to almost 50 million.[45] All through the stroke of the pen. So much for the original intent of the income tax amendment to tax only the top 3 to 5 percent of the people.

The most significant problem with these acts from 1939 and 1943 acts was the distinction between wages and income in the nature of profits and gains were forever clouded.[46] Whereas the term income previously was understood to mean the gain derived after deducting ordinary and necessary expenses, and the statutory exemption prior to these years covered those expenses for the individual human, those understandings disappeared during this transition period. Wages and salaries magically were transformed into gross income and without those ordinary and necessary expenses being deducted, were equated with profits and gains. Are wages income? Yes, but are wages taxable? Possibly, but only after deducting ordinary and necessary expenses. Only after deducting those ordinary and necessary expenses can there possibly be a gain that can be categorized as “taxable income.” When forgetting this important cornerstone, the income tax remains an indirect tax in the nature of an excise with respect to businesses and other artificial entities, but is a direct tax with respect to humans. The 16th Amendment rendered moot the issue of direct taxation without apportionment, but the inability to deduct ordinary and necessary expenses of life certainly defies the intent of the 16th Amendment. But in the heat of war most people did not notice the psychological effect of this new “pay as you go” tax system.[47]

Recall from the original 1913 revenue act that any wages and salaries received in “excess” of the exemption ceiling were to be treated as income, although those receipts were not income as that word was commonly understood to be used within the 16th Amendment. The illusion of gain was created by mere statutory fiat, but at least the exemption purposely covered the ordinary and necessary expenses of life. Nor was the “gain” passive in the nature of unearned income, which early proponents of the income tax wanted taxed. Nonetheless, the door was opened in 1913 to allow for this confusion and conversion into a mass tax.

Because of the massive currency inflation caused by World War II, somewhere around 1943–1944 the cost of living exceeded the statutory exemptions. [Comment: Need data.] Since then the cost of living has far exceeded the statutory exemptions and standard deduction. In 1913 the exemption ceiling was three to six times the average salary. Today the statutory exemption and standard deduction is approximately one-tenth the average cost of living. But war, as is so often witnessed throughout history with various other events, seemed to have firmly entrenched the income tax into the American persona.

After World War II ended, Americans restarted the process of building families, businesses, and communities. An economic boom began that lasted many years. American wages and salaries increased, and most Americans had by then fully accepted the concept of withholding at the source, but legislators failed to restore the exemption ceiling to keep pace. Legislators failed to raise the exemption rate or standard deduction until 1969. The primary excuse was the Cold War. Many people of the period saw the 1913 tax as a “class tax,” and the taxes of World War II as emergency taxes. Nevertheless, because of the early confusion introduced in 1913 with the term income, Americans began paying “income” taxes on any wages and salaries that exceeded the statutory exemption ceiling. Only a generation after World War II and the ruse was complete.

These war time legislative acts opened the door for court judges and legal scholars to proclaim that wages and salaries were income subject to taxation. The camel was fully inside the tent.

Finis.

Terms of Use Next: Chapter 14: Wages Are Income — Mistaking the Camel for a Horse Table of Contents Bibliography Endnotes [1] Volume 38 Statutes at Large, 63rd Congress Session I, Chapter 16, section II, p. 166, enacted October 3, 1913. [2] Volume 49 Statutes at Large, 74th Congress Session I, Chapter 531, p. 620, enacted August 14, 1935. [3] 295 U.S. 330 (1935). [4] Volume 48 Statutes at Large, 73rd Congress Session II, Chapter 868, p. 1283, enacted June 27, 1934. [5] 301 U.S. 548 (1937). [6] 301 U.S. 619 (1937). [7] Volume 53 Statutes at Large, 76th Congress Session I, Part I, enacted February 10, 1939. [8] Volume 53 Statutes at Large, 76th Congress Session I, Chapter 59, p. 574, enacted April 12, 1939. [9] 17 U.S. (4 Wheaton) 316 (1819). [10] Helvering v. Gerhardt, 304 U.S. 405, (1938). [11] Graves v. New York, 306 U.S. 466 (1939). [12] O’Malley v. Woodrough, 307 U.S. 277 (1939). [13] Volume 54 Statutes at Large, 76th Congress Session III, Chapter 419, p. 516, enacted June 25, 1940. [14] Volume 54 Statutes at Large, 76th Congress Session III, Chapter 419, section 7, p. 519. [15] Volume 54 Statutes at Large, 76th Congress Session III, Chapter 419, section 6, p. 519. [16] Congressional Record, 76th Congress Session III, Congressman Allen of Illinois, p. 7961, June 11, 1940. [17] Volume 55 Statutes at Large, 77th Congress Session I, Chapter 412, section 111(a), p. 696, enacted September 20, 1941. [18] Volume 56 Statutes at Large, 77th Congress Session II, Chapter 619, section 131(a), p. 827, enacted October 21, 1942. [19] Volume 56 Statutes at Large, 77th Congress Session II, Chapter 619, section 131(b), p. 828. [20] Volume 56 Statutes at Large, 77th Congress Session II, Chapter 619, section 450, p. 884. [21] Volume 56 Statutes at Large, 77th Congress Session II, Chapter 619, sections 475–476, p. 892. [22] Doris, The American Way in Taxation, pp. 115–120. [23] Volume 38 Statutes at Large, 63rd Congress Session I, Chapter 16, section II (E), p. 169, enacted October 3, 1913. [24] Volume 40 Statutes at Large, 65th Congress Session II, Chapter 63, section 1204(2), p. 332, enacted October 3, 1917, repealing section 8(d) of the 1916 act. Withholding remained in effect for non-resident aliens: sections 1025, 1208. [25] Twight, “Evolution of Federal Income Tax Withholding,” p. 369. [26] Volume 57 Statutes at Large, 78th Congress Session I, Chapter 120, p. 126, enacted June 9, 1943. [27] Twight, “Evolution of Federal Income Tax Withholding,” p. 362. [28] Shlaes, The Greedy Hand, p. 4. [29] Twight, “Evolution of Federal Income Tax Withholding,” pp. 360, 364–365. Examples of the many propaganda posters used during this period are available at http://www.taxhistory.org/Civilization/poster.htm. [30] Stang, Tax Scam, pp. 216–217, citing a declassified Senate Finance subcommittee confidential hearing regarding the 1942 Revenue Act, which included testimony from Meyer Jacobstein of the Brookings Institution. [31] Doherty, “Best of Both Worlds,” http://www.reason.com/9506/FRIEDMAN.jun.shtml. [32] Twight, “Evolution of Federal Income Tax Withholding,” p. 377–378. [33] Volume 58 Statutes at Large, 78th Congress Session II, Chapter 63, p. 21, enacted February 25, 1944. The act was oddly named because the legislation applied to 1944 and thereafter. [34] Volume 58 Statutes at Large, 78th Congress Session II, Chapter 63, section 106, p. 31. [35] Volume 58 Statutes at Large, 78th Congress Session II, Chapter 210, section 9, pp. 236–238, enacted May 29, 1944. [36] At an average currency inflation rate of 3.5 percent, the equivalent amount for 2005 should be $4,220. The actual amount allowed for a single person was $3,200. [37] Volume 58 Statutes at Large, 78th Congress Session II, Chapter 210, section 6, pp. 234–235. [38] Volume 58 Statutes at Large, 78th Congress Session II, Chapter 210, section 8, pp. 235–236. [39] Crane, “The Income Tax and the Burden of Perfection,” p. 177. [40] Congressional Record, 78th Congress Session II, p. 4703, May 19, 1944. [41] The text in this paragraph is derived from http://www.taxhistory.com/revenue.html. [42] Shlaes, The Greedy Hand, p. 3. [43] Benson and Beckman, The Law That Never Was, Vol. II, p. 13, citing Gabriel Kolko, Wealth and Power in America (Frederick A. Praeger, New York, 1962), p. 33. [44] Twight, “Evolution of Federal Income Tax Withholding,” p. 370. [45] Ekirch, “The Sixteenth Amendment,” p. 182. [46] Dickstein, Judicial Tyranny, pp. 7–8. [47] Shlaes, The Greedy Hand, pp. 4–5.

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